What Happens If The Dollar Loses Its Status As Reserve Currency?

by: Larry Swedroe


China is evidently moving towards a more market-driven economy, as shown by the doubling of the trading range for the yuan.

China revamping its financial sector often causes alarm among U.S. investors concerned the dollar will lose its status as the world’s reserve currency.

“Dollar scare” is just more media hype investors should ignore.

Earlier this month, the People's Bank of China announced that it would double the allowable trading range for the yuan against the dollar to 2 percent from a midpoint rate it sets every day. This move provides evidence that the government is moving toward a more market-driven economy.

I've noted that there's a direct correlation between announcements that China continues to send signals that it's revamping its financial sector, loosening its grip on the its currency, the yuan, and calls/emails I get from investors worried about what will happen if the dollar loses its status as the world's reserve currency.

The questions started coming with frequency when the U.S. financial crisis began to impact the stock market in November 2007. At that time, the U.S. Dollar Index (a weighted average of the price of various currencies relative to the dollar) was trading at around 76, having fallen from around the 84 level at the start of the year. Investors were becoming increasingly alarmed by the fear that the dollar was about to lose its status as the world's reserve currency. At the time, many were talking about the Euro taking on a much bigger role.

Contributing to investor concerns about the dollar was the Federal Reserve's unprecedented easing of monetary policy, beginning with driving interest rates to zero. And when that proved insufficient, they began their program of quantitative easing (buying bonds). The concern was, and remains, that the easy money policy would lead to a rapid increase in inflation. All of the noise created by the financial media about these concerns was adding to the stress investors were feeling.

We know today that the financial crisis turned out to be the worst we faced since the Great Depression. And the Fed continues to maintain its zero rate policy while more than tripling its balance sheet. In addition, the economic recovery has been tepid, at best. Yet, despite all that bad news, after hitting a low of about 71.5 in April 2008, as I write this in mid-March, it's trading at about 79.4. And the euro has fallen from a high of about $1.60 in 2008, to about $1.39. As to the runaway inflation investors were worried about, it has averaged about 2 percent, well below the 3 percent it averaged since 1926. And investors, including bond guru, Bill Gross, who were preaching to avoid long-term bonds because of the risks, ended up with not only egg on their faces, but with the problem of reinvestment risk confronting them.

There's Nothing New in Investing, Only the Investment History You Don't Know

Investing via the rear view mirror isn't generally a good idea as it leads to performance chasing - buying what has done well (at relatively high prices) and selling what has done poorly (at relatively low prices). However, used correctly, the rear view mirror can provide us with the right lesson. As Spanish philosopher George Santayana warned: "Those who cannot remember the past are condemned to repeat it."

With that in mind, we'll go to our trusted "videotape." Prior to the dollar taking that role, the British pound was the world's reserve currency. It lost that status shortly after World War II. Not only that, but Britain industrial capacity was devastated. So, how have British stocks performed since? We have data on the FTSE All-Share Index going back to February 1955. Given these conditions, you'd think that U.K. stocks would have done poorly relative to U.S. stocks. And you'd be dead wrong. From February 1955 through February 2014, the FTSE All-Shares Index returned 11.0 percent, outperforming the S&P 500 Index, which returned 10.3 percent.

There's almost always bad news sufficient to scare investors. And the last five years have certainly provided their share. However, despite all the bad news and the plethora of crises, equity markets around the globe have provided spectacular returns since the bottom was reached in early March 2009. Unfortunately, because of the prior bear market and all of the continuing problems, many investors missed all or most of the rally, as it wasn't until late in 2012 that equity mutual funds began to experience net inflows.

The great tragedy is that investors persistently make the same mistakes, like selling after periods of bad performance (when expected returns are higher) and buying after periods of good performance (when expected returns are lower). Buying high and selling low isn't exactly a prescription for investment success. The best way to avoid making that mistake is to have a well-developed plan and stick to it, ignoring the clarion cries from the gurus, who don't know what they don't know.

The lesson the rear view mirror teaches us is that what may seem painfully obvious at the time, may turn out to be very wrong. The other lesson is that paying attention to economic and market forecasts is a recipe for likely failure because the academic research demonstrates that there are no clear crystal balls, only very cloudy ones.

However, for investors who are concerned by the shifting status of the dollar, my next post will address the appropriate actions to take.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.